Employee or Independent Contractor?
ARTICLE | October 26, 2022
As an employer, it is important to classify your workers as either employees or independent contractors correctly. This classification should be made not only at the time of hiring but any time the working relationship changes.
Incorrectly classifying workers can have serious legal and financial consequences. Employees are entitled to certain rights and benefits under the law, including minimum wage and overtime pay. Independent contractors, on the other hand, are not entitled to these same rights and benefits. Also, independent contractors and employees are subject to different tax rules. As such, it is important to correctly classify workers in order to avoid not only potential legal problems but also tax penalties down the road.
In this article, we’ll discuss the difference between employees and independent contractors and why it matters. We’ll also cover factors to consider when determining how to classify your workers.
What is the difference between an employee and an independent contractor?
The difference between an employee and an independent contractor isn’t clear or simple. When most people think of employees, they picture someone who works directly for a company, usually in an office or other workplace. Independent contractors, on the other hand, are typically self-employed and work on a more project-oriented basis.
The main difference between employees and independent contractors is that employees have a direct employer-employee relationship, while independent contractors are effectively self-employed. This means that employees are covered by traditional employment law protections, such as minimum wage and overtime rules, while independent contractors are not. Independent contractors also tend to have more control over their work schedule and are usually not eligible for benefits like health insurance or paid vacation days.
The hiring and onboarding process tends to be different for employees and independent contractors as well. Potential employees typically submit an application that is reviewed by a business’s Human Resources Department. The Human Resources Department then makes a job offer and, if accepted, requests the employee to provide additional information such as forms I9 and W-4. Then, the employee will usually receive formal training as part of the onboarding process.
Independent contractors, on the other hand, tend to deal only with the business department that needs the contractor’s product or service. They typically complete a proposal and enter into a contract with the company for a specific deliverable. They are usually not subject to any formal training or set schedules.
Factors to consider when classifying workers
When classifying employees and contractors, it all comes down to the amount of control and independence a worker has. While there is no bright-line rule defining employees vs. independent contractors, there are a host of factors to consider when classifying workers. These include behavioral, financial, and relationship factors.
Behavioral factors look at how the worker does their job. Specifically, what is their role compared to other workers? What do they do? Do they work set hours? How do they request or take time off? Does the company have control over the worker, and if so, how much control? Can the company dictate how the worker does their job?
Essentially, the more control the business has over the worker and their role, the more likely they are to be considered an employee and not a contractor. Typically, contractors have deadlines and specific deliverables, not set daily or hourly schedules. If a company directs when, where, and how work is done, this control indicates an employee/employer relationship.
Financial factors consider various aspects of the business relationship. For instance, does the worker pay for their own equipment and tools to do the job? Are their expenses reimbursed? How is the worker paid? Do they pay for their own travel?
If the worker has made a significant investment in their own business, such as investing in their own tools, equipment, and travel, they are more likely to be classified as an independent contractor.
Finally, businesses need to analyze their relationship with the worker to determine whether they are an employee or independent contractor. Is the worker free to take on other clients? Is there an ongoing relationship between the business and the worker? Is the worker paid benefits? Do they only have access to limited information necessary to complete a specific project?
The closer the relationship between the worker and the business, the more likely they are to be considered an employee.
However, these factors are considered in their entirety, not necessarily independent of one another. If a number of behavioral, financial, and relationship factors all point toward the business exercising significant control over a worker, they will likely be classified as an employee and not a contractor. For instance, a worker may pay for their own tools (something typically associated with contractors) but still be considered an employee because a number of other factors establish an employee/employer relationship.
Why does the classification matter?
The distinction between employees and independent contractors is important for tax purposes because it also determines who is responsible for paying taxes on the income earned from working.
Employees have taxes withheld from their paychecks by their employer, and the employer also pays a portion of the payroll taxes. Independent contractors, on the other hand, are responsible for paying their own taxes. This means that they must set aside money from each payment they receive in order to pay their taxes each quarter or at the end of the year.
It’s also worth noting that the IRS takes this distinction very seriously. Misclassifying employees can lead to lengthy and costly investigations (as well as potential penalties and interest). Moreover, the tax forms that you have to complete will differ depending on how your worker is classified. Specifically, a W-2, W-4 and I9 are used for employees whereas a W-9 and 1099-NEC are used for independent contractors.
What if you are unsure of a worker’s status?
If you are still unsure whether to classify a worker as an employee or independent contractor, you can file Form SS-8 with the IRS. The form can be filed by the business or the worker, and the IRS will review the facts to determine the worker’s status. While the review can take up to 6 months to get a response, it can be a worthwhile endeavor to avoid the investigation and penalties associated with misclassification.
The IRS is not the only regulatory agency concerned with a worker’s status. Each state also has tests to determine a person’s status under workers’ compensation and unemployment insurance laws. Therefore, it’s important to check with your state’s department of labor to learn about its criteria for employee versus independent contractor.
This article is intended to provide a brief overview of the difference between employees and independent contractors and is not a substitute for speaking with one of our expert advisors. If you would like help in determining proper classifications for your workers, please contact our office. We’d be happy to discuss your unique situation.
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HMA CPA offers a full range of tax, accounting and consulting services for closely held businesses, their owners, and high net worth individuals. We value relationships and are committed to providing close, personal attention to our clients. Though our experience spans over 35 years in the accounting field, we also keep current with ongoing professional education so we can provide you with outstanding technical support and customer service.
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